Interview with John Cochrane

There are many interesting bits from the interview, sometimes polemic bits too, here is one excerpt:

EF: What do you think are the biggest barriers to our own economic recovery?

Cochrane: I think we’ve left the point that we can blame generic “demand” deficiencies, after all these years of stagnation. The idea that everything is fundamentally fine with the U.S. economy, except that negative 2 percent real interest rates on short-term Treasuries are choking the supply of credit, seems pretty farfetched to me. This is starting to look like “supply”: a permanent reduction in output and, more troubling, in our long-run growth rate.

There is a good macroeconomic story. In a business cycle peak, when your job and business are doing well, you’re willing to take on more risk. You know the returns aren’t going to be great, but where else are you going to invest? And in the bottom of a recession, people recognize that it’s a great buying opportunity, but they can’t afford to take risk.

Another view is that time-varying risk premiums come instead from frictions in the financial system. Many assets are held indirectly. You might like your pension fund to buy more stocks, but they’re worried about their own internal things, or leverage, so they don’t invest more.

A third story is the behavioral idea that people misperceive risk and become over- and under-optimistic. So those are the broad range of stories used to explain the huge time-varying risk premium, but they’re not worked out as solid and well-tested theories yet.

The implications are big. For macroeconomics, the fact of time-varying risk premiums has to change how we think about the fundamental nature of recessions. Time-varying risk premiums say business cycles are about changes in people’s ability and willingness to bear risk. Yet all of macroeconomics still talks about the level of interest rates, not credit spreads, and about the willingness to substitute consumption over time as opposed to the willingness to bear risk. I don’t mean to criticize macro models. Time-varying risk premiums are just technically hard to model. People didn’t really see the need until the financial crisis slapped them in the face.

I’ve long believed the risk premium is the underexplored variable in macroeconomics and finally this is being rectified.

‘I’ve long believed the risk premium is the underexplored variable in macroeconomics and finally this is being rectified.’

Because the idea that a capitalist economy demands growth leads to an uncomfortable examination of value, which the marginal revolution was designed to avoid, insisting that questions about a better world were placed outside of the realm of ‘objective’ economics?

‘This moment in the late 19th century marked a turning point in economy theory. With the introduction of these theories, the analysis of production and exchange turned away from social theory and towards the quest of a scientific objectivity. Classical economics had focused on the causal relations among social activities, which were connected with the production and distribution of wealth. Classical economists asked questions about the true basis of value, activities that contributed to national wealth, systems of rights, or about the forms of government under which people grow rich. But in the late 19th century, in response to attacks from socialists and debates about how society works, and as a means to escape the conundrums of value theory and to answer how values could become prices, economists developed the theory of marginalism. This disengaged economics from descriptive and normative commitments with the aim to withdraw economics from debates about how society worked and what kind of society we wanted to live in, and escalate it to an objective and universal realm.’ http://en.wikipedia.org/wiki/Marginalism#The_Marginal_Revolution

In other words, the marginal revolution of that age was all about avoiding the very issue of a better world.

This argument that “it is too long for demand side problems to persist so we have supply side problems” is incredibly very cheap. There are numerous ways this has been addressed. There are examples – like for instance that incredible coincidence that economic recovery in Japan coincided after decades of 0 inflation just coincided with loosening of monetary policy that produces very mild 1% inflation. And Japan has even more excuses for why they are in “great stagnation” period, aging of population being the prime example.

Then there are some theoretical arguments: from those that for instance Market Monetarists say (that it is all about expected path of monetary policy) to those of Gerge Evans – that even relatively small shift in real interest rate may change the path of ecnomy from deflation teritory to safe stable equlibrium, link here: http://www.youtube.com/watch?v=g53gFvPT5Lg

But why should anybody bother with arguments when simply stating ” after X years of bad monetary policy, monetary policy is surely irrelevant” sounds so good. So maybe it is all about “THE RISK”. Only first – this idea is nothing new, FT Alphaville basically does not write about anything else and second – nobody understands how this should work, all discussions end up muddled in the swamp of jargon and word games not dissimilar to what is going on with MMT.

So long story short: I don’t buy Cochrane’s patronizing where he repeats the same line that was discussed many times before without bringing anything new, and I also do not buy that some mysterious “RISK” should be the explanation without saying HOW. It is equally easy to say that economy is not doing good because of “PHLOGISTON”.

So is NGDP above pre-crisis peak? Yes. Is it higher in USA compared to Eurozone? Yes. Is USA doing better then Eurozone in terms of unemployment? Yes. Is there any space for USA to grow more more quickly? I don’t know but I would very carefully say that yes. Putting on a confidence face and pushing a sophisticated argument that “SURELY by now everything should be fine on the aggregate demand side” does not seem right to me. USA has easier monetary policy than Eurozone and it works. Japan has easier monetary policy now than it had before and it worked. And most importantly there is a lot of space of how to work on easier monetary policy even without stressing “standard” interest rate signal as it was widely used before recession. For instance nobody know what are NGDP expectations in USA. Maybe we are no a precipice of another collapse and we will experience another recession even before interest rates are back to “normal” (in a good way).

But maybe all this aggregate demand talk is garbage and we should all acknowledge the results of this new “risk” theory. So what is out there? Where can I find some basic simple model explaining how should this work? Where is at least some blogpost measuring risk differences between Japan, USA, Eurozone and the impact it had on business cycle? I really am very interested but so far my search was frustrated. And I do not think that this view is automatically right just because it is new.

Well, you could look at the delta of private debt held by participants in the national economies of those countries. It’s not a perfect measure but if people are deleveraging heavily, then it points towards the fact that people think that the future is riskier than they thought the future was, say ten years ago.

Must the fact that QE “works” at ensuring (anemic) GDP growth point to the fact that this ISN’T a supply-side problem? QE could be pushing a low number a bit higher, but not actually helping, which would explain why we’ve had QE for five years now and the “demand problem” seems to still be there… maybe it’s not a demand problem. Japan has had QE for 13 years, it sure jumpstarted their economy back on the right track!

Yes this is surely true for USA. With close to 7% unemployment the usefulness of further monetary easing is diminishing, but this may still be very important for another recession. And there truly is something wrong with our current situation. I know that Nick Rowe was thinking about at least in 3 different posts mostly discussing it as “inflation inertia” and still without definitive answer.

For me the biggest signal is that we still cannot return to “normal” interest rates except by tightening monetary policy which has very negative and immediate impact – as was with FED taper talk a few months ago. I think that Cochrane’s reasoning that slight changes of interest rate somehow obviously and intuitively *cannot* have impact on the economy are misguided. To explain why I first have to say that I am a great fan of Nick Rowe (and George Evans) multiple equilibria explanations for interest rates. Nick likes to talk about it as trying to balance a plate on a pole. If you want the plate (long term interest rate) to move right (increase), you have to move the pole to the left (decrease interest rate), then leave gravity to move the plate to correct position and then quickly catch it up so that you end up to the right of your original position (with higher interest rates). George Evans explains similar thing about dynamic properties of New Keynesian model with learning. Even slight decrease of real interest rate may nudge us from bad unstable equilibrium to good equilibrium so that in the medium-to long run the economy gets back on track into a good equilibrium and so that paradoxically interest rates can the be increased without fear – or rather that interest rates will *have* to be increased to prevent the inflation.

So to make this short my biggest problem with Cochrane here is that he is trying to explain why demand is not a problem purely based on what he deems as intuitive. This is doubly wrong especially considering that we have positive evidence that up to this moment easing monetary policy had positive impact on economy in USA, Eurozone and Japan and that we do not have any persuasive examples of supply side problems such as longer period of high inflation.

Yes this is surely true for USA. With close to 7% unemployment the usefulness of further monetary easing is diminishing, but this may still be very important for another recession.

No, additional demand can improve the economy greatly even if unemployment remains at 7% or only declines slightly. First, if those counted as ‘no in the labor market’ enter the labor market to take a sudden increase in jobs, then the unemployment rate may remain the same or even increase while actual jobs explode. Second, real GDP or GDP per person is the primary measure here. Unemployment, ‘jobs’ etc. are secondary measures. Third, employment may remain unchanged but wages increase (either by additional hours worked or higher salaries/rates). This leads me too…

What I’ll say over and over again. The only way to measure how much of the problem is supply is by exhausting the possibility of demand. Increase demand until you start seeing inflation pick up to the north of 2-3% rather than the south but you see no improvement in employment. At that point whatever you are left with can be fairly called a ‘supply problem’ and we can talk about it from there.

Cochrane’s statement just seems to be non-sequitur piled on non-sequitur. Why can we no longer “blame generic demand deficiencies?” Very little in the way of a Keynesian solution was done to alleviate them and has mostly faded away. Standard monetary policy (low interest rates) and QE worked as well as was anticipated – i.e. not very much once rates got near 0%. It seems to me you can’t eliminate a cause without making a serious effort to address it and efforts to address inadequate demand have fit that description.

Stagnation persists because everyone – investors, savers and consumers – all know that government action is required but unlikely to occur given the state of the congress. Governmental leaders continue to be enthralled by the myths of deficit and debt that continue to provide the necessary support for their inertia. The reduction in output will only persist until the inertia is overcome by the rational policies that cannot be avoided forever.

Whether they believe that government can cure the ills of the economy is irrelevant. Even non Keynesians know that if the government spends it buys from businesses and at the very least those businesses do better. Investors invest in the businesses they think will get the spending and some borrow for investment so interest rates go up so savers save. What is it you don’t get about this?

The Japanese government practiced pretty massive stimulus spending for a protracted period of time and yet their growth remained slow. So, at the very least, there’s that example as a case in point that stimulus spending won’t necessarily “fix” the US economies current low growth.

Also, I suggest you read (or at least read the summary) of Tyler Cowen’s book “The Great Stagnation”, which implies that the current low growth isn’t just a fiscal issue.

We are not Japan. And we are not Greece either so we should at least try real stimulus spending before we write it off. And – unlike Japan – we have a great deal we could profitably be investing in. Infrastructure, education – get the teachers back by putting some money out to the states – and plenty of social services we could be getting out to people that would spend the money.

“We are not Japan. And we are not Greece either so we should at least try real stimulus spending before we write it off.”

First, you have failed to indicate how we would be better at stimulus spending than the Japanese. Just saying that somehow we are more competent at government spending than Japan without even attempting to provide any details is not a compelling argument.

And secondly, the US clearly did try real stimulus spending . To say otherwise is just ignorance.

And the US stimulus spending probably shaved a good 2-3 points off the unemployment rate at least. Economic theory is very clear about what happens when you have ‘too much’ stimulus. Long term interest rates should shoot up (as gov’t competes with the private sector for investment funds), inflation should pick up, unemployment should fall but real-GDP should fail to rise. None of that has happened. What evidence is there that either the US or Japan has done ‘too much stimulus’?

LF, +1. I really liked Cochrane’s premise: “we’ve left the point that we can blame generic “demand” deficiencies.” What a joke. Having a sequester (reduction), rather than increasing spending. Funny thing is, if one branch is stuck so it can’t do anything, at least the Fed can act, but what should be admitted is when you are in a liquidity trap, everything looks like there is excess supply.

Yeah, sort of like North Carolina’s increased spending on education. It was less than cost increases attributed to inflation or increases in student numbers. GOP only likes dealing in real figures when it cuts their way. Same with the sequester.

Inflation? The Fed has a certain amount of inflation as a target, so that justifies enpixelating more money to give to teachers? No, no, if a low level of inflation is supposed to be good, if money is supposed to be increasingly worthless, then what’s the point of giving public employees raises to match it? What kind of a goofy treadmill is that, which fixed income folks and pensioners get to watch while public employees salaries go up on the basis of orchestrated inflation? The public employees in this country hold everybody else in serfdom, you’ll notice how many cops quit to become truck drivers.

You miss the point. The governor said he increased spending on education when in fact he decreased it in real and per student terms. He can’t provide the same level of resources this year without increasing spending by at least the rate of inflation and he can’t provide the same resources for each student without increasing spending by enough to cover a greater student population. The state failed on both counts.

Both the Great Depression and Japan lasted for over a decade. It just so happened that they got out of the slump at the same time that demand recovered.

As a general rule, liberals overestimate short-run effects and conservatives overestimate long-run effects. There are many issues, such as minimum wages, where liberals essentially pin their hopes to the short-run lasting for awhile, until employers of low-wage workers automate or go out of business.

But all the evidence points to the adjustment in wages being quite long indeed, on the order of decade or more, when nominal demand fails to recover. Wholesale shifts in wage rates downward simply do not happen like the price of oil or corn going down. Managers have relatively little reason to cut wages instead of firing people and/or reducing hours. In theory, they could increase market share by offering lower prices than everybody else. But that means hiring people. Who is going to lower wages across the board and then actually increase the number of workers? That just doesn’t happen. The laid off workers may prefer it, but the laid off workers’ opinions don’t matter. It’s the incentives of the managers which matter, and there is no incentive to cut wages in most industries, with regular long-term employees. In some industries with very transient employment, there is highly variable compensation.

Now, over the VERY long term, wages do go down, but almost entirely through attrition. That means, to reset to a lower wage rate, a company’s entire workforce has to turn over. Like I said, the long-term is a decade or more, which the Great Depression and Japan bear out.

“That means, to reset to a lower wage rate, a company’s entire workforce has to turn over. ”

I don’t think that is entirely correct. If wage increases are significantly below the rate of inflation, then wages will bottom out before one would expect the entire workforce to turn over. Granted, that may be a 10 year period versus a 20 year period, but it will still be quicker.

Imagine that a regulation banned all coal -fired electricity generation (save that which is scrubbed clean) and all gasoline-driven transportation. For the purpose of a thought experiment, assume an adequate transition to other forms of generation and transportation. The total capital cost would be about $400 billion for the electricity substitution (about 300 gigawatts), and about 10m x $40,000, or about $400 billion for the vehicle substitution. The coal-generation would not be phased out absent the regulation so this is truly new spending. The 10m extra cars assumes that the current turnover rate of 10m-15m units a year is increased by 10m more in order to acccomplish the phase out more quickly. So here’s my question: is this plan a supply side or a demand side “stimulus”? Oh btw it would also be a STW plan, where STW stands for “save the world.”
P.S. This is in total the same order of magnitude of the 1990s substitution of packet switched for circuit switched communications.

In the long run (20 year time frame) the increasing amount of cheaply produced wind power generated by the US (the world leader in wind power production) coupled with cheap natural gas will effectively cap the US price of electricity below the rate of inflation. Assuming current trends continue (which is always a big assumption) the US should have a significant cumulative economic advantage due to cheap electricity.

Wind farms rarely produce anywhere close to what the nameplate says, and requires significantly more upkeep than what is claimed by its proponents. And, by its nature, it cannot be used for baseload production. Very expensive and wasteful backup is necessary.

Generally, US commercial wind power has a capacity factor of roughly 30%. So, yes production is only 30% of “name plate capacity”. However, the relevant factors are cost and actual production, not capacity.

I’m not sure what precisely you’ve heard about the maintenance factor. Certainly it’s not trivial, but neither is it anywhere near the fuel costs for a natural gas plant.

The link I listed above about Levelized costs includes the cost of maintenance in the total value. Wind has the highest Operations and Maintenance costs of $13.1/megawatthour, but that is more than offset by a $0/megawatt fuel cost. For comparison, natural gas has an O&M cost of only $1.7/megawatthour, but a fuel cost of $48.4/megawatthour.

“And, by its nature, it cannot be used for baseload production. Very expensive and wasteful backup is necessary.”

This is the biggest issue with Wind Power. It has a high intermittency that must be actively compensated for. However, the grid always has to have backup power to deal with routine scheduled maintenance, unexpected grid issues, low rain fall (which can significantly effect hydro-power production in any given year), etc. In all likelihood this will limit US wind power production to roughly 20% of current electrical production unless cost effective power storage is incorporated into the mix.

However, wind is cheap enough that at some point pumped hydro and maybe compressed air storage will be added to levelize production. There has been a lot of talk about battery storage, but with the current level of technology batteries are not cost effective.

The US is spending about 8-9% of it’s GDP on ‘energy’. Of that the bulk is probably being used for transportation and non-electric heating. Let’s say half. So maybe 4% of GDP is paying for simple electricity to power things like TV’s, laptops and lights.

If electricity suddenly became somewhat cheaper either because of a massive increase in ‘free wind power’ or to use a right-wing wet dream massive nuclear power plant construction, the impact on GDP is probably not going to be all that much.

Now let’s say a UFO lands and offers us infinite electrical energy for $0. Well then things might shake up a bit more dramatically. If electricity is free in unlimited amounts then the economy would probably switch over transportation to electricity. That’s maybe 10% of GDP. But no one advocating either wind/solar or massive nuclear plants is proposing that electric will get that cheap. Even so, it sounds to me like you’re talking about a one time 20-30% growth in GDP? That would be like jumping from about 1999 to today instantly. Impressive but not exactly totally earth shattering.

On the supply side you would have to ask the question what could the economy produce today with all it’s coal plants versus tomorrow after all those plants are replaced with whatever your proposed regulation proposes to replace them with. If GDP in that future state is greater then it’s a ‘supply stimulus’ I suppose. But then people will ask given a free market, why wouldn’t that switch happen without regulation and the increased GDP be captured by profit seeking investors?

What’s interest IMO if the regulation causes the total potential GDP to fall. The result would NOT be rising unemployment, in fact it could lower unemployment. Millions could be hired to put up solar panels or teach classes on nuclear power plant management but total real GDP would fall. A fall in supply should mean that it gets harder to produce the same output with the same number of workers and capital. A response might be to stop the fall in GDP by adding more workers and capital (i.e. bring the long term unemployed back into the labor market). But technically you’d still see a decline in GDP per person while at the same time seeing fewer unemployed people.

WWII demonstrated this pretty well. The massive build up in demand clearly eliminated all unemployment. It did not expand GDP. A typical person in 1945 couldn’t live much better than they were living in 1941. They couldn’t buy a new car, would have had trouble eating more steak, would have found gas rationed. (For this purpose let’s ignore the value of war goods to GDP). That’s what a ‘supply short fall’ should look like. You can get a job but despite working 20 hours overtime every week you can’t live any better because the economy can’t produce guns AND butter.

Therefore if the problem since 2008 has been supply then why should there be an unemployment problem!?

Look, if you have a house that you think has leaky pipes it’s going to be almost impossible to confirm that if the main water is shut off. The easiest way to diagnose your problem would be to turn on the water and then see one by one if there’s any leaks. Trying to find a leak without water pressure in the system is going to be nearly impossible.

Likewise if you don’t think our problem is demand, well pump up demand. Push demand until you start seeing inflation north of 2-3% rather than south of 2% per year. At that point if you still can’t get unemployment less than 6% or real GDP growth up then you’ll demonstrate there’s a supply problem.

John Cochrane’s assertion that the problem can’t be demand it’s just ‘far fetched’ for a demand shortfall to last so many years sounds pretty pathetic to me. Why isn’t it equally far fetched to assert a supply problem could last so many years? After all the economy looks radically different today than it did in 2007/8. We’ve had big changes in capital (the real estate market, the financial markets) as well as the labor force. What are the chances that this mysterious ‘supply problem’ wouldn’t have gotten unclogged during all that shaking?

“This is starting to look like “supply”: a permanent reduction in output and, more troubling, in our long-run growth rate.”

Is “supply” a reference to “income to consumers”, a reference to “wealth transfers to consumers called subprime debt that will be discharged in bankruptcy”, or something else?

My sharp reduction in consumption, and thus reduction in demand, is driven by my reduction in income which is driven by industry and politicians who want capital prices to inflate by preventing the creation of new productive capital and the destruction of existing productive capital.

The past three to four decades have been devoted to destroying a significant part of the 19th century railroad system in order to reduce the supply of productive capital to inflate the price of the railroad capital. The price of the railroad capital is not based on the super high value of the rail infrastructure and its high performance globally, but instead is based on the rent seeking on the 19th century government monopoly grants. It is the recognition of the government monopoly grants of right of way that is behind abandoned right of way reverting to government ownership.

Highways are decaying because industry is unwilling to pay enough to use them to maintain the highways. Reagan signed a 125% tax hike Jan 6 1983 which was sufficient to double highway construction spending just to restore the highways to about 1970 performance. Bush-Clinton hiked taxes 100% to maintain the highways, not to expand them. Inflation and higher efficiency vehicles have reduced the budget to maintain the rapidly decaying highway infrastructure to less than 50% of what is required to replace the bridges built more than half a century ago that had design lifetimes of an average of 50 years.

But blocking paying for road capital, industry has inflated their capital prices for trucking franchises by paying only half the cost of using the public road capital.

Similar analysis applies to power generation and distribution – industry does everything possible to prevent long term capital investment in power production because that would prevent inflation of capital prices of existing power generation capital. Imagine a trillion dollars invested in one million wind turbines in the US connected by a robust power grid – the price of power generation would be driven down to return on capital from revenue plus operating and depreciation costs over a three decade plus investment cycle – existing coal and nuclear power plants would see their capital prices collapse as they would be unable to provide the load following, while gas cogen would reap profit from load following while paying for capital costs with the process heat or waste disposal inherent in cogen.

I find a lot of magical thinking in public-private partnerships – by going to Wall Street to build highways and railroads and power systems, it is possible to reap profits off public infrastructure without charging higher prices to use the public infrastructure because Wall Street will find a way to inflate the price of decaying physical capital to generate capital gains. Just like Wall Street funded lots of real estate debt that was never possible to repay.

I guess the business cycle just isn’t as good as it was in 2002-2005 when making loans that have no chance in hell of being repaid was a good risk to take.

Is “supply” a reference to “income to consumers”, a reference to “wealth transfers to consumers called subprime debt that will be discharged in bankruptcy”, or something else?

I think the only thing that makes sense is ‘supply’ is the amount of output (i.e. GDP) an economy can produce given so much input. Who gets to ‘enjoy’ that output, such as consumers eating Big Macs or businesses buying new machines, is another question. (Although that question may impact supply in the future).

A ‘supply problem’ then implies that the economy cannot produce more GDP because it either lacks the ‘inputs’ (not enough people, or as you speculate no enough of the right type of capital) or something has happened to make those inputs less productive (say some new regulation makes it harder to use either workers or capital to their best).

The past three to four decades have been devoted to destroying a significant part of the 19th century railroad system in order to reduce the supply of productive capital to inflate the price of the railroad capital.

The only problem is that this doesn’t work. If I own 30% of the railroads and I just choose to destroy them that may indeed make the price of railroad capital go up. But it will be my competitors who will reap that benefit, not me. So why would I do it? I would ‘destroy’ my railroad capital if the possible income I could earn from it is not enough to cover the cost of depreciation and decay. That sort of thing happens a lot and happened in the 19th century when a lot of railroads went bankrupt.

Likewise if Microsoft destroys Bing, it will probably help Google. But that wouldn’t help Microsoft!

So yes in theory if people decided to stop working, or businesses decide to destroy perfectly good capital then yes you may create a ‘supply problem’ which causes GDP to fall. What’s interesting, though, is that there should be evidence of a supply shortfall. Unemployment should go down, not up. The profits someone makes by building a new railroad (or search engine) should be higher, not lower. Where’s the evidence of this today?

It would be great to see more academic economists discuss risk premia. The ones running the Fed – and whose research is sponsored by the Fed – lack an understanding of how overstimulation is distorting risk premia. The best data I’ve ever seen on the risk premium is Ibbotson’s conclusion that the risk premium for US equities has been about 6% since the 1920s. That used to be quoted in CFA materials.

” I think we’ve left the point that we can blame generic “demand” deficiencies, after all these years of stagnation. … This is starting to look like “supply”: a permanent reduction in output and, more troubling, in our long-run growth rate.”

Cochrane’s been pitching the same line since 2008. I suppose he’s bound to be right eventually.